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How to divide profit between a partnership?

Hi All

I've recently started this hosting company with a friend of mine, but I'm not too certain on how the profits are to be split. We've registered as a 50 /50 partnership, but of course, in some cases, one does more work than the other.

Assuming that there is an imbalance, how would you cut the revenue between the two partners?

One idea I was thinking about was, even though it's a joint account, if one partner does all the work for the client, then he is entitled to the full profit of that client, but that gets terribly confusing. Anyone here in a similar situation and with experience on how to handle this?

This should have all been sorted out when you entered the partnership. You should have legal documents explaining how all revenues and expenses are passed on to each partner. I wouldn't move forward until you have those documents signed and sorted out. The two of you should sit down and discuss how you want to divide everything up. If it is truly 50/50 then that is the answer to you question. You might want to seek legal advice as I am not a lawyer.

I have experienced in exactly this situation. The solution that we used is to divide profit exactly the same as the ownership ratio. However, we also have salary expenses that are strictly paid for the works performed. Whoever works more get paid more, with a pre-arranged rate that is fair and acceptable for both the working and non-working partners.

Of course, all partners need to work out the specific rate for each type of work and how that is paid. Get that agreement and you are done. If you can't get that agreement, the partnership is in need of serious review.

While the argument may sound valid to you: That doesn't mean it sounds valid to your partner.

I don't want to just re-echo everything said: but again you're going to want to have everything settled before moving forward or it's only going to get worse.

My recommendation would be to offer a lower % split of the profits - let him/her know that they don't have sufficient time to input into the company but you still want to give them a piece until they finally can properly input.

Go as low as possible of course -- and obviously they do have some qualities as you originally chose them as a partner: but that doesn't mean to drag the rest of the business down. You'll only work hard for so long for only half the profits yourself, i.e. you'll stop inputting and it will die.

If he can't see that then terminate and "buy him out" or start something new.

A big problem will be how do you tell if one person does more work than the other? Is it hours logged, tickets closed, or just a vague idea that someone was there more often than the other?

Unless you want to be greedy and squabble over a bit of money, you should either split profits 50/50, or set up an absolutely objective means of being paid for some form of work performed. Eg. maybe you get a base amount, and then get paid per ticket closed.

The alternative is to give each person an area of responsibility (eg, one person does billing and customer support, the other does technical support) and just split the profits 50/50 - if one part of the business is more work than the other, too bad. As long as each gets paid enough, then there shoudn't be room for petty and immature jealousy over 'I worked more than you' arguments.

Obviously, all the above may not apply to your situation as you havn't told us enough to properly describe the problem, but the fundamental advice is not to let any bad emotions get in the way of what should be profitable for both of you.

From an accounting standpoint, it would be difficult because, well there are only two of you and there is bound to be a dispute over labor (hours). Typicallly, what you would do is, and it has been a while since my accounting classes, is that any physical property dedicated to the business becomes the property of the business. Your interest is the initial contribution of assets to the business.

Essentially, your business is only as valuable as the assets put into the business. Unfortunately, labor is an expense and should not be counted towards assets contributed to the business unless you agree with your partner to conduct business only in the office and use timecards or some form of measurement that you both agree on.

So lets say John and Larry decide to open a business. John contributes $700 cash to start the business while Larry contributes $300 cash. The total businesses value is now $1000. This $1000 goes towards purchasing office equipment such as a couple of desks, chairs and lamps. Now they are out of money again. John throws $600 into the pot and Larry goes out and buys a computer for $400. Since the business can not pay Larry $400 for the computer, the computer is added as a contribution from Larry of $400. Now if we look at the assets, we should have a business worth $2000 on paper. John contributed $1300 and Larry gave $700. This would make John owner of 65% of the business while Larry owns 35%. Now lets say that John goes out and gets some business and Larry does nothing. John gets a payment of $2000 for the work he did. We add this to the cash, which is an asset. so now our hypothetical business is worth $4000 on paper. This would make John's share worth $2600 and Larry's share worth $1400. Ouch. Larry's share of the pot just doubled and he didn't have to do any work. But by the same token, John agreed with Larry that if anyone wanted out of the partnership, the partner would have first opportunity for buyout. Another way to leverage ownership over a partner who does little or less work is to contribute more (put your profites back into the business) to the business as you go along. This will eventually diminish their overall percentage of ownership. This is also the reason why there is such a thing as a silent partner in business - they make financial contributions into the businesss but do no work.

This of course is a strictly cash-based ownership model - stocks would make it overly complex for such a simple partnership.

The alternative is to give each person an area of responsibility (eg, one person does billing and customer support, the other does technical support) and just split the profits 50/50 - if one part of the business is more work than the other, too bad. As long as each gets paid enough, then there shoudn't be room for petty and immature jealousy over 'I worked more than you' arguments.

Obviously, all the above may not apply to your situation as you havn't told us enough to properly describe the problem, but the fundamental advice is not to let any bad emotions get in the way of what should be profitable for both of you.

Thanks gbjbaanb for the insight. This makes a lot of sense to me. I guess first things first, which is

a) Allocate responsibilities
b) Sign agreement

I already contacted a lawyer about this, here's the update for you guys:
1. We strongly recommend to our clients that they enter into a partnership agreement (for partnerships) or shareholders agreement (for corporations). These agreements deal with not only how profits are distributed and what the obligations of each partner are (as per your email), but also (and perhaps more importantly) with:
a. how the business will raise money if needed;
b. what decisions can be made by either partner, and what decisions need the consent of both partners;
c. whether a partner can transfer his interest or shares in the business to a third party without the consent of the other partner, and the procedure around such transfer; for example, you may wish for a partner to have a first right to purchase the other partner's shares/interest, and if that partner does not want to purchase, the selling partner can then sell to a third party;
d. what happens if a partner dies (ie, do you want to be in business with the person who will inherit that partner's shares/interest after death?):
e. what happens if a partner becomes disabled;
f. what happens if there comes a time when the partners can no longer get along (ie, by including "exit" mechanisms like a "shotgun" forcing one partner to buy out the other);
g. whether a partner, both while he is a partner and after he leaves the business, can compete with the business

2. We do not have a fixed fee for a partnership/shareholders agreement. Our fees are based on time. For a straightforward agreement, our fee would be in the range of $1600-2500.

3. If you only want to deal with profit distribution and obligations, you and your partner could simply agree between yourselves as to how those matters will be dealt with, and write down on paper the agreed terms. You don't need a formal, written agreement prepared by a lawyer. The benefit of a formal agreement prepared by a lawyer is that (a) you can deal with all of the matters listed above (which I strongly urge), (b) the lawyer can guide you to deal with things that you might not otherwise think about, and (c) the formal agreement will (hopefully) more clearly reflect your agreement in the event a judge ever has to look at it and figure out what was agreed to.